According to Fed chairman, Jerome Powell, “Inflation is low and stable”, but given that “growth is running at a healthy clip…and wages are up” the Fed is clearly anticipating rising inflation and is tightening monetary policy accordingly. So, how should equity investors respond to higher inflation?
At its September Open Market Committee meeting last week, the Federal Reserve decided to increase US interest rates for a third time this year. According to Fed chairman, Jerome Powell, “Inflation is low and stable”, but given that “growth is running at a healthy clip…and wages are up” the Fed is clearly anticipating rising inflation and is tightening monetary policy accordingly. So, how should equity investors respond to higher inflation?
The chart below shows the relative performance of various equity categories during discrete inflation regimes since September 2001. The so-called “listed real assets” of listed property, listed infrastructure and resource equities tend to perform in line with, even slightly ahead of, broader global equities during inflationary periods similar to what we’re seeing currently (2-3%). Over the past four months, the annual inflation rate in the US has crept up towards the upper end of this range. But as the chart demonstrates, listed real assets have more clearly outperformed the MSCI World Index when inflation exceeds 3%. Could this be a sign of things to come, and what drives this behaviour?
Source: FTSE Global Core Infrastructure Index, FTSE EPRA/NAREIT Developed Index, S&P Natural Resources Index, MSCI World Index, US CPI (Urban Consumers Non-Seasonally Adjusted). All in USD and sourced from Bloomberg. Sep 2001 to Sep 2018
Many infrastructure assets have explicit links to inflation through regulation, concession agreements or contracts.
Toll roads provide a good example of this. Their concession terms typically reference the inflation rate, with scope to negotiate further compensation for additional capital expenditure. Australian toll road company, Transurban Group, for example, can increase prices on many of its roads by the greater of inflation or 4% pa. Similar concession agreements where tolls are linked to inflation exist throughout Europe, North America and even across emerging markets.
The regulated pricing of water, electricity and gas utilities across the US and Europe are also often connected to inflation rates. Even infrastructure assets without specific links to inflation can have the pricing power to deliver a similar (or better) outcome, reflecting a strong strategic position. The track networks of North America’s two main freight rail companies are examples of unique infrastructure assets that can’t be replicated. Significant numbers of captive customers, such as grain handlers and auto producers, give them strong pricing power over long haul routes.
The connection between rental growth on properties and the rate of inflation varies across property type and jurisdiction.
For a purpose- built logistics asset, tenants could negotiate 12-15 year leases with annual rental increases based on inflation. For retail property in Australia, specialty tenants pay base rent with increases each year (either a set increment or linked to inflation) over a typical five year lease. In contrast, larger tenants in these assets usually pay flat contracted rents plus a percentage of their sales turnover, which is clearly related to rising prices.
Finally, the relative performance of resource equities is often influenced by commodity prices, which feed into headline price inflation.
This is particularly relevant currently, with oil prices rising to four-year highs in September. If energy prices continue to rise, it is worth looking out for even higher, albeit less likely in our view, inflation environments when price growth moves above 4%. Resource equities perform particularly well in this scenario and listed infrastructure continues to deliver solid returns. Even listed property might be expected to outperform the MSCI World over these periods. However, during the Global Financial Crises, when US inflation was initially running above 4%, listed property uncharacteristically underperformed the MSCI World as broader share prices fell heavily. Property could offer a better inflation hedge during similar periods in future.
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